Atticus Lowe was among those who saw more smoke than fire in the fevered puffery of the shale industry's promoters. With an established track record now, the industry has proved its potential for him, and he is bullish on gas over the long term. He shares his assessment of some of the promising oil and gas players in this interview with The Energy Report.
The Energy Report: A couple of years ago, you were skeptical of the long-term prospects of the U.S. shale-gas plays being touted by producers. Has anything happened to give you more confidence in the forecasts?
Atticus Lowe: Commercial production has been established in a number of shale plays, although most require a significantly higher natural gas price to justify the economics. As these shale plays have developed, a number of sweet spots have been established that provide higher-than-average returns. This is the old 80/20 rule, where 80% of the production may come from 20% of the acreage. The sweet spots in some of these plays are economically viable in the current price environment, but the vast majority of the acreage in most of these plays will require at least $5 per thousand cubic feet ($5/Mcf) in order to make them work.
I'm surprised by how well natural gas production has held up in the face of very low prices over the past few years. Early on in the history of shale development, prices were multiples of where they currently are, so the economics worked and people were excited about it, paying high prices for the acreage. A lot of producers curtailed production when prices dropped, and a lot of that production has come back onto the market, now that prices have recovered a bit. Probably the biggest factor, though, is the natural gas byproduct that is associated with the liquids-rich shale plays.
In the Marcellus shale play, for example, the producers make their money on the liquids, and they can practically give away the gas and still make money on their drill programs. That has resulted in a lot of extra natural gas supply, which has really kept prices tempered. But natural gas liquids prices are getting pressured pretty hard, so some of that drilling is slowing down. Over the last few weeks, domestic production has actually started to decline. Winter weather has been cold, compared to last year especially, so we're actually slightly below the five-year average in terms of natural gas storage. When you combine that with the recent declines in production and rig counts, it sets up a pretty bullish case for natural gas. The natural gas drilling rig count just reached a new 14-year low. If another cold blast hits this year and production continues to decline, we could see easily another $1–2/Mcf increase in price for gas.
TER: Can a dry gas well justify the exploration and production (E&P) cost or does it have to have liquids?
AL: The vast majority of dry gas plays are not economic in this price environment. Operators have largely already switched their drilling plans in favor of oil and liquids-rich targets. Even if gas prices increase another $1/Mcf or even $2/Mcf, I don't know if it's enough to swing the pendulum back toward natural gas drilling. The economics of the liquids plays, especially the oil-prone plays, are just much better. Producers are also pushing for the exportation of liquid natural gas outside of the U.S., which I think will happen in the next few years. That will create a new market for the gas and new demand for it, while reducing the supply here and increasing the price. I'm definitely bullish on gas over the long term, but in the short term we could still have some bumps. The energy equivalent price for natural gas right now is approximately $25 per barrel ($25/bbl) compared to crude oil, and that disparity just won't last over the long term.
TER: What are the prospects for natural gas as a transportation fuel?
AL: The future is big. It's being used now for dump trucks and city transportation. There's a push toward utilizing natural gas for long-haul trucking fleets, but I'm disappointed that more hasn't been done to realize the potential for consumer auto fuel. It would save consumers a lot of money and, create a lot of jobs and provide a big boost for the economy. It would also reduce our dependence on foreign oil while creating a positive impact on carbon dioxide emissions, people's health and the environment. It's one case where I think the government could actually help get the ball rolling, with a tax incentive or some sort of stimulus. I'm really surprised that this hasn't gained more traction.
TER: Your three-pronged investment strategy focuses on management, assets and catalysts for growth. Which companies excel in all three of these areas?
AL: Apache Corp. (APA:NYSE), ConocoPhillips (COP:NYSE), EnerJex Resources Inc. (ENRJ:OTCBB),GreenHunter Energy Inc. (GRH:NYSE.MKT) and Sonde Resources Corp. (SOQ:NYSE) all offer a compelling value proposition at the current prices and are catalyst rich.
TER: How has Sonde's offshore Tunisia oil development performed?
AL: Its exploration program has been very successful. The company has established a huge oil and gas reserve base, and there is a strong market for the gas in that area as well. The gas there is nearly as valuable as the oil. On top of what it has already discovered, there is tremendous potential to discover new reserves. The exploration prospects that remain on Sonde's acreage block have a much more favorable risk-reward profile compared to most international offshore prospects. Sonde has established a large reserve base that can be economically developed on a standalone basis, and it is being developed now.
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TER: Have the revolutions in Tunisia and Libya affected that project at all?
AL: Yes, and I'd say more so Tunisia, where there has recently been a shakeup in the government. Sonde recently secured an attractive farm-out arrangement for its North African assets. The arrangement is a good deal for the company, and it's also a great deal for the government because the proposed partner is large and can bring great resources to the project. The partner is Viking Energy North Africa, Ltd., a private company backed by the Thome Group, based out of Singapore. That group is one of the largest shipping companies in the world, and it also manufactures the offshore production facilities for developments like Sonde's.
Under the agreement that Sonde struck, all of the development costs associated with its established reserves, known as the Zarat discovery, will be carried by Viking, and Sonde will retain a 33% carried interest. On top of that, Sonde will essentially be carried for three exploration wells, which have the potential to multiply the resources that have already been discovered there. This deal was struck at the end of 2012, and it was expected to be completed around the end of Q1/13, but it appears that Sonde has not been able to get the Tunisian government to sign off on the transaction. That is really puzzling to me given the merits of the deal, but I assume that the recent government shakeup in Tunisia has delayed the process. It's really a win-win for both the company and Tunisia, and making it successful will also help Tunisia attract additional foreign investment as opposed to discouraging it if the deal is rejected. If the transaction doesn't get approved for some reason, then I expect that Sonde will simply finance the development through a different type of deal structure, which should provide it with the same economic benefit.
TER: How does the farm-out benefit Sonde?
AL: It gives it exposure to a very large amount of cash flow, which is slated to begin in 2015 at virtually no cost to Sonde. In fact, Sonde should easily generate more cash from this project in its first year of production than its entire enterprise value right now. Its partner will contribute hundreds of millions of dollars to develop the project and bring it online, and Sonde will reap 33% of the benefits at virtually no further cost. Each of the exploration wells that it will be carried on is estimated to cost approximately $25 million ($25M). So it has substantial benefits, especially for a company the size of Sonde.
TER: Sonde's Western Canadian Strategic Alternatives Process is preventing the company from committing to a capital program in 2013, according to its recent annual report. How will that affect its ability to grow shareholder value this year?
AL: Sonde is a very small company that's extremely asset rich, and I think it is flying totally under the radar of investors. Right now, the company is trying to close the Tunisia deal and figure out where and how to allocate capital and whether it should sell assets. The stock is absurdly cheap regardless of how these processes play out, and I think the company could fetch a multiple of its current price if it wanted to sell. Outside the North African assets, the company has the potential to unlock a substantial amount of value this year via a number of different catalysts, including from its Western Canada asset portfolio. The company has hired FirstEnergy Capital out of Calgary, which is a premier investment bank, to run a strategic review process for its Western Canada assets. Basically, the company put all of its assets into a data room, and numerous companies are getting an opportunity review and bid on the properties.
That includes approximately 100 thousand (100K) acres in the Duvernay play and 50K acres in the Montney play, both of which are red hot right now. This acreage can fetch up to $10K/acre or more if it is successfully proven up. There is a lot of activity in the area, and a lot of acreage has been proven up in areas surrounding Sonde's position. In addition, Sonde owns 100K acres in two other emerging oil resource plays. The company also produces more than 2 thousand barrels oil equivalent per day (2 Mboe/d) from more conventional properties.
Sonde currently has a market capitalization of only $70M. In addition to its producing assets, Sonde has nearly $20M of net cash on its balance sheet, plus all of the undeveloped assets that I mentioned, both the resource play assets and the North African assets. The stock is around $1.15/share right now. I think the shares can fetch $5 once the company figures out its path in Tunisia and completes its strategic review process in Canada. If just a portion of the Western Canada resource play acreage turns out to be productive, we could see a ten-bagger in this stock. I believe a lot of this will play out over the next 12 months. As Warren Buffet says, "Be greedy when others are fearful and fearful when others are greedy." I think it's time to be greedy with Sonde.
TER: EnerJex's price recently jumped from around $0.50 to the $0.65 neighborhood after declining for the last year. It's now at $0.57. Is that a portent?
AL: I will say first that I am a director of EnerJex, so I am biased. I was involved in the transformation of the company at the end of 2010. At that time, EnerJex completed a comprehensive transaction that included multiple acquisitions and a significant infusion of equity capital. The board is very focused on per-share value creation.
The stock was over $1/share a couple of years ago, so it really hasn't made up much ground, but the company's performance has been outstanding. It has rapidly increased production, cash flow and proven reserves. I believe there has been a lot of selling pressure over the past two years from vintage shareholders. The supply of shares appears to be starting to dry up, so the supply and demand dynamic is changing. EnerJex is attractive because it has a large inventory of shallow conventional oil drilling opportunities. Unconventional shale plays are desirable due to their repeatability, and EnerJex has a lot of repeatability in its Eastern Kansas asset base, which is rare. Most conventional plays have been largely tapped out or are on their third legs, so this is unique.
I also think the economics associated with EnerJex's drilling portfolio are better than most, if not all, of the big shale plays. The company has a market capitalization of only $45M. It has approximately $10M of very low-interest rate debt and yet it has nearly 3 million barrels (3 MMbbl) of proved oil reserves and a large undeveloped asset base. In addition, the company has nearly $10M of additional liquidity through its senior credit facility, which bears interest at 3.75% per annum. The company just reported that it has identified 400 drilling opportunities in one of its oil plays. Those opportunities are not factored into its current reserve report. It expects to earn into 1K additional acres in its Mississippian play next month, which will provide a significant amount of additional reserve exposure.
EnerJex actually repurchased 2M shares of its common stock at the end of 2012. It's very rare for a microcap E&P company to repurchase such a significant amount of stock. It speaks volumes about the board's conviction for the equity and also its confidence in management's ability to execute the business plan. The company's CEO, Robert Watson Jr., works as hard as anybody I know. His father runs Abraxas Petroleum Corp. (AXAS:NASDAQ), which is also a publicly traded oil and gas company. Robert has gained a lot of experience being a third-generation oilman. He also has a significant amount of private equity experience and knows how to build a company. He personally owns a large stake in EnerJex and is determined to be successful.
TER: GreenHunter started in 2005 as a renewable-energy company. In 2009, it changed its business strategy to focus on water-resource management related to the oil and gas industry, and its stock plummeted. How have investors responded to that?
AL: I don't think the stock went down as a result of the change in its business plan. I think it was a number of other factors that were all occurring around the same time, including a major hurricane that wiped out its largest asset. It was a difficult time a few years ago for the market in general, and especially for small companies focused on renewable energy. The company went through a tough period and had to reinvent itself, but the new business plan is fantastic. Investors have definitely started to respond favorably. The stock climbed from $0.85 per share in 2012 to nearly $3.50 at one point. The shares have fallen back since that time to about $1.50 where they appear to have stabilized.
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TER: That $3.50 was a momentary peak. It lingered at levels lower than that, but it is back down now. Water-resource management for the oil and gas industry is an utterly different business from renewable energy development. Is the management equally knowledgeable about both missions?
AL: The company has completely shifted its focus away from renewable energy. It's only focused on the water-resource management business right now. Most companies that were in GreenHunter's position a few years ago have gone out of business. The fact that GreenHunter has stayed alive and is actually flourishing now is a testament to management's experience and tenacity. Management is much more experienced in the water-resource management business due to its deep experience and relationships in the oil and gas industry.
TER: Has the asset base been converted to serve the new strategy?
AL: Absolutely. The company has been innovative in the products that it's brought to market, and it's been on the forefront in the very early stages of this emerging industry. It's growing rapidly as a result. The company recently reported a 1,400% increase in revenue for 2012. It also reported adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) of more than $5M for the year. The company is now positioned in a number of the big shale plays or resource plays in the U.S., including the Eagle Ford shale, the Mississippian Lime, the Marcellus shale, the Utica shale and the Bakken shale. The company is only scratching the surface, but it has established early positions in these major plays that it should really be able to leverage over time.
GreenHunter provides soup-to-nuts water-management services for the oil and gas industry related to drilling, completing and producing hydrocarbons from the shale plays. These plays are developed through horizontal drilling, and they're completed utilizing fracture stimulation technology, which requires a tremendous amount of water through the whole cycle of drilling, completing and producing, including disposal. The industry is still in its infancy, and the growth opportunities are staggering when you consider the size and scope of these shale plays in the U.S. and how much water is involved in that process.
Based on management's track record, Gary Evans' in particular, I expect the company to build and sell. I think this will be a takeout at some point in the future, and I do think there's quite a bit of runway before the company sells out. GreenHunter has been able to access a lot of capital and favorable terms through the issuance of perpetual preferred stock, which is yielding over 13% now, and this security is listed on a major exchange. GreenHunter is forecasting revenue growth of more than 100% in 2013. I think as it continues to grow, it will get on a lot more radar screens than it is on now and have a lot more exposure to institutional investors that are looking for these types of growth opportunities.
TER: Apache and ConocoPhillips are two others you mentioned. They're in a different league entirely from these three. What are your thoughts that you wanted to share on them?
AL: We look at the whole spectrum of E&P companies, from microcap to super major. These are two stocks that really stand out to me as being attractive investment opportunities. Conoco recently spun off all of its midstream and downstream businesses, so it's no longer an integrated company. It's now the largest independent oil and gas company in the country. The spinoff has proven to be successful for shareholders, and I think it may be the start of a trend for the bigger players. Conoco is attractive because it is very cheap and it has an outstanding undeveloped asset base. It trades at about 4.5 times EBITDA and $12/bbl of proved reserves. It has an incredible land position, in the middle of the sweet spots in a number of the big resource plays like the Eagle Ford, the Bakken and the Duvernay up in Canada. It has a tremendous amount of drilling to do in those plays, which should have very strong economic returns. The stock yields 4.5%, which is very attractive in this low-interest-rate environment.
Apache is probably even cheaper than Conoco. It also has a very strong margin of safety as a result of the valuation. The stock is near a five-year low despite continued growth and also despite an asset portfolio that would be very attractive to a larger player. Apache is a big company. It has a $30 billion ($30B) market capitalization, but it's trading at only 3.5 times EBITDA and around $15/bbl proved reserves. It could definitely attract a suitor. Conoco could as well, even though Conoco is a much bigger company than Apache, with a market cap north of $70B. These companies both have big acreage positions in big plays that would be really attractive to a larger company, especially at their current valuations. They could be accretive for larger companies and offer a lot of drilling opportunities. Apache is the number-one driller in the Permian basin, where it has a huge footprint.
TER: Is consolidation coming to the gas industry?
AL: For gas in particular, there have been a lot of willing buyers, who are contrarian and want to buy at the low, but I don't think there have been as many sellers as people expected because the sellers are also expecting gas prices to increase. I do think, though, in this business, in general, you either buy or get bought eventually. So the industry will always be prone to consolidation.
Right now is a particularly interesting time because of the low interest rate and the emergence of new domestic resource plays. A lot of these plays are evolving and some smaller companies have gotten into these plays and built acreage positions. One in particular, Osage Exploration and Development Inc. (OEDV:OTCBB), has developed a significant position right in a very attractive area of the Mississippian Lime play. This is an area that is dominated by much larger companies that are flush with cash. Companies like Osage that are small and have really attractive acreage positions in plays that are being dominated by the big boys are logical takeout candidates at some point. That will continue to be a trend in the future as smaller companies acquire acreage in the emerging resource plays.
TER: I appreciate your time today.
Atticus Lowe is the chief investment officer of West Coast Asset Management, Inc., a founder and principal of Montecito Venture Partners, LLC, and a director of Black Raven Energy, Inc. He has been a featured speaker at the Value Investing Congress as well as the Value Investing Seminar in Molfetta, Italy. He is a CFA charterholder and holds a Bachelor of Arts in economics and business from Westmont College.
By Tom Armistead